Rational Investors And Nudging

As much as people like to assume investors are rational, the opposite is usually true…

I’ve observed investors respond to similar events very differently from one point in time to the next.

For example, on some occasions in the financial markets, the prospect of stronger economic growth has led to a belief that inflation will follow. This suggests interest rates will rise… and that company profits will suffer as the cost of debt rises. So the incentive to invest to grow businesses (and earnings) will diminish. As a result, investors sell shares.

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But similar data points can provoke the exact opposite reaction in stock markets. On some occasions, expectations of stronger economic growth has led to a belief that earnings will be good… which is good for companies. So investors buy shares.

The difference in reactions is because of the way that investors choose to judge potential outcomes from a similar set of economic circumstances. In short, there’s no one, set “rational” way for investors to react.

Economics isn’t the science it pretends to be

Universities around the world run courses and degrees in the “Social Sciences”. These include subjects like sociology, anthropology, geography, psychology, demographics, politics, criminology and of course, economics.

As a young undergraduate, I fully agreed with the definition of my study of economics as “science” of a kind. Much of what we studied in economics was based around statistical testing of hypotheses, charts, graphs, tables and spreadsheets. All of this seemed to give the study of economics a sort of scientific credibility based on numbers and facts.

Economics told us that humans, both individually and collectively, behave in rational ways… ways that could be explained by statistically observable data. And economics is all about trade-offs… people behave rationally in pursuing the greatest amount of satisfaction given income and resources. We were told that people respond to incentives, and that market prices reflect the balance of demand and supply for goods and services.

But it soon became apparent that while the subject matter of economics may be amenable to factual and statistical analysis, the simple reality is that economics is the study of the collective behaviour of many millions of individuals. And that people often, individually or collectively, do not behave in the way that the models of economics predict.

In short, they often behave irrationally, at least according to conventional economic thinking.

Economics is the study of collective behaviour

Numerous economists and academics have brought behavioural psychology to the study of how we make economic and financial decisions.

Last week, the Nobel Foundation awarded the Nobel prize in economics to perhaps one of the most noted and colourful behavioural economists, University of Chicago’s Richard Thaler. Along with Hersh Sefrin in the early 1980s, Thaler put forward an “economic theory of self control”. In simple terms, this describes how people cannot, or do not, control their impulses.

Example: People can be counted on to have the motivation to pick up a $20 bill they see lying on the footpath. But they are very likely going to have a hard job resisting the temptation to spend that $20. They lack the self control to put away cash for retirement.

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It is this lack of will power that ensures that most people don’t put away enough money for their retirement.

Thaler (and others) made lots of what might seem like minor, almost irrelevant observations about human behavior not being truly rational. But they demonstrated that many of these can and do have profound impacts on economic outcomes.

For example, the behaviouralists note that we are much more concerned about losing something that we already have than not acquiring it in the first place. (The net outcome is exactly the same. So from an economic viewpoint, this behavior is irrational.)

I’ve noticed this in real life in Hong Kong. I frequently pass a gas station that sells the liquid petroleum gas for taxis, at a price that is a couple of cents cheaper than other places. The queue of taxis in line wanting to not spend a few cents can stretch for a quarter mile down the street. Drivers can take the best part of an hour to get filled up.

It would be more rational to pay a bit more for the gas at a station with no queue and spend that wasted hour picking up paying customers. But that’s not what happens. These taxi drivers are more concerned about losing the money they already have then losing out on money they could be making.

Then there is what Thaler called the “endowment effect”. Here, people put a higher value on things when they own them. I see this all the time (and have been subject to this effect myself) in the real estate space. People often place a much higher value on property that they own, than they would be prepared to pay themselves in the open market.

Another is the “status quo bias”. This means that people tend to continue with what they have – whether it’s a frame of mind or belief or asset – already rather than make a change, even if that change could provide big gains from a small cost.

These behaviours can have big economic and financial implications.

For example, in his book written with Cass Sunstein, “Nudge: Improving Decisions About Health, Wealth and Happiness”, Thaler and Sunstein explain how irrational flaws and biases pervade our thinking and our actions. But a simple, and often very subtle, nudge can encourage us to make much better economic and financial decisions.

The most well publicized version of the “nudge” effect comes from the pension arena.

Now, this is a subject that I have harped on for years. Far too many people are woefully under provided for their retirement. Quite simply, they have not put away enough money during their lives.

Thaler suggested that a very simple change in pension policy could encourage far more people to be better provided for retirement. The simple nudge is to switch the pension policy from where an employee explicitly needs to decide to participate in a company pension plan, to a default that enrolls him/her automatically – but with the ability to decide not to participate if so desired. The freedom of choice still remains.

Under the automatic enrollment scheme, far more people end up saving into pension plans. The pension regulator in the UK has reported that participation in private pension schemes increased from 42 percent to 73 percent in the period from 2012 to 2016 after default enrollments were put in place. A total of just 12 percent explicitly decided not to participate in the private pension scheme.

The “nudge” effect has had big impact on pensions in the U.S. and Sweden as well.

If we were truly rational, it would not matter whether the default was to participate, or not participate, in the scheme. We would simply judge the cost and benefits and decide accordingly. But clearly, we are not totally rational. And this very small, and very simple policy “nudge” can have substantial impacts on a large number of lives and the finances of countries.

Again, while human behaviour might seem inconsequential when it comes to economics, it can have big financial implications.

So the next time you go to make a financial decision, think about whether or not it’s a rational one.